In the past, financial statements’ users rarely judged prospect of businesses based on balance sheet where investors put more weight on the short-run maximization of earnings per share concern. The emphasis in FASB’s Conceptual Framework Project on the asset-liability approach to accounting theory—in response to the great inflation and recession during the year of 70-an—brought the balance sheet back on the table for more serious discussion on it.
The shift has marked a departure from the traditional transaction-based concept of income toward a capital maintenance concept.
Under the capital maintenance approach to income measurement, the amount of beginning net assets would be compared to the amount of ending net assets, and the difference would be adjusted for dividends and capital transactions.
By using the approach, it was asserted that investors would theoretically be better able to predict the overall profit potential of the reporting enterprise. Since that time, the balance sheet became even more important than the income statement to stakeholders: the management, investors, creditor and regulators.
Not only about balance sheet became extremely important. In addition to it, necessary informative disclosure is required by the accounting standard because, without the information they provide, the financial statements would be misleading.
Here are eleven necessary disclosures that are used in varying degrees in contemporary balance sheet:
1. Parenthetical Explanations
2. Notes to Financial Statements
4. Valuation allowances
5. Supporting Schedules
6. Accounting Policies
7. Related Parties
8. Comparative statements
9. Subsequent Events
And here are the explanations:
Instead of just “Common stock = $2,500,000”, balance sheet would states “Common stock ($10 par value, 300,000 shares authorized, 250,000 issued) = $2,500,000.” That is a “Parenthetical Explanations.”
Such information is sometimes disclosed by means of parenthetical explanations appended to the appropriate balance sheet caption. It places the disclosure prominently in the body of the statement instead of in a note or schedule where it is more likely to be overlooked.
Notes to Financial Statements
If certain information can’t be disclosed in a relatively short and concise parenthetical explanation, a note disclosure is used, instead.
“Inventories (see Note-5) = $8,550,000”
The notes to the financial statements would contain the following:
“Note-5: Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method.”
In addition, all significant contractual commitments are to be disclosed in the notes to the financial statements. For example, lease contract provisions, pension obligations, requirements contracts, bond indenture covenants, commitments to purchase or construct new facilities, and employee share-based compensation plans are to be clearly disclosed in the notes.
Certain balance sheet accounts often cross-reference another account on the part of the balance sheet. Cross-referencing is used when there is a direct relationship between two accounts.
Among the current assets, the following might be shown if $2,500,000 of accounts receivable were pledged as collateral for a $2,200,000 bank loan:
“Accounts receivable pledged as collateral on bank loan payable = $1,500,000”
Included in the current liabilities would be the following:
“Bank loan payable—collateralized by accounts receivable = $2,200,000”
Certain assets and liabilities’ carrying amounts are decrease or increase by using “valuation allowance” overtime. Accumulated depreciation for example, reduces the carrying value of property, plant, and equipment. Bond premium (or discount) increases (or decreases) the face value of a bond payable as shown in the following illustrations:
Plant = $20,000,000
Less accumulated depreciation = $(2,000,000)
Bonds payable = $20,000,000
Less discount on bonds payable = $(1,500,000)
Bonds payable = $20,000,000
Add premium on bonds payable = $ 1,800,000
A supporting schedule might be used to provide additional detail about an item in the financial statements.
Example: Consolidating schedules might be included in addition to the basic consolidated financial statements or a five-year summary of selected financial data might be included.
In general, supporting schedules are not used to provide information required by GAAP because those schedules are not part of the basic financial statements and are typically subjected to only limited procedures by auditors.
There are many different methods of valuing assets, recognizing revenues, and assigning costs. Financial statement users must be aware of the accounting policies used by enterprises so that sound economic decisions can be made.
According to the current accounting standard codification, the disclosures are to identify and describe the accounting principles followed by the enterprise and methods of applying those principles that materially affect the determination of financial position, changes in cash flows, or results of operations. The accounting policies disclosure is to encompass those accounting principles and methods that involve the following:
- Principles and methods peculiar to the industry
- Selection from acceptable alternatives
- Unique applications of GAAP
Note, however, the accounting policies disclosure need not duplicate information provided elsewhere in the financial statements. These usually appear in a separate section called “Summary of Significant Accounting Policies.”
In simple words, a related party is essentially any party that controls or can significantly influence the management or operating policies of the company to the extent that the company may be prevented from fully pursuing its own interests.
Related parties include affiliates, investees accounted for by the equity method, trusts for the benefit of employees, principal owners, management, and immediate family members of owners or management.
Transactions with related parties are to be disclosed even if there is no accounting recognition made for such transactions (e.g., a service is performed without payment). Another part of the current standard codification, financial statements are required to disclose material related-party transactions other than compensation arrangements, expense allowances, or other similar items that occur in the ordinary course of business (ASC 850, “Related-Party Disclosures.”)
Note, however, disclosures are not permitted to assert that the terms of related-party transactions were essentially equivalent to “arm’s-length” dealings unless those claims can be substantiated. If the financial position or results of operations of the reporting enterprise could change significantly because of common control or common management, disclosure of the nature of the ownership or management control is required, even if there were no transactions between the entities.
The disclosures to be included are:
- The nature of the relationship
- A description of transactions and the effects of those transactions reflected in the financial statements for each period for which an income statement is presented
- The dollar amount of transactions for each period for which an income statement is presented and the effects of any change in the terms of such transactions as compared to the terms used in prior periods
- Amounts due to and from related parties as of the date of each balance sheet presented, together with the terms and manner of settlement
In order to increase the usefulness of financial statements, many enterprises include financial statements for one or more prior years in their annual reports. Some also include 5- or 10-year summaries of condensed financial information.
These comparative financial statements allow investment analysts and other interested readers to perform comparative analysis of pertinent information.
The current FASB’s standard codification states the presentation of comparative financial statements in annual reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the enterprise (ASC 205.) That presentation emphasizes the fact that the statements for a series of periods are far more significant than those for a single period and that the accounts for one period are but an installment of what is essentially a continuous history.
The balance sheet is dated as of the last day of the fiscal period, but a period of time usually elapses before the financial statements are issued. During this period, significant events or transactions may have occurred that materially affect the company’s financial position. These events and transactions are called “subsequent events.”
The omission of disclosure of significant events occurring between the balance sheet date and issuance date of the financial statements could mislead the reader who is otherwise unaware of those events.
There are two types of subsequent events, per SAS 1 (auditing literature), “Subsequent Events”:
- Type-1. Events that provide additional evidence about conditions that existed at the date of the balance sheet and which affect the estimates inherent in the process of preparing financial statements.
- Type-2. Events that provide evidence with respect to conditions that did not exist at the date of the balance sheet but arose subsequent to that date.
The first type results in adjustments of the financial statements. The second type does not require adjustment of the financial statements but may require disclosure in order to keep the financial statements from being misleading. Disclosure can be made in the form of explanatory notes, sometimes supplemented with pro forma statements.
1. The second type of events (those not existing at the balance sheet date) that require disclosure but not adjustment include the following:
- Sale of a bond or capital stock issue
- Purchase of a business
- Loss of plant or inventories as a result of fire or flood
- Gains or losses on certain marketable securities
2. A loss on an uncollectible trade account receivable that results from a customer’s deteriorating financial condition, which led to bankruptcy subsequent to the balance sheet date, would be indicative of conditions existing at the balance sheet date, thereby calling for adjustment of the financial statements before their issuance.
3. A settlement of a lawsuit would require adjustment of the financial statements if the event that gave rise to the claim occurred prior to the balance sheet date. However, only disclosure is required if the event that gave rise to the claim occurred after the balance sheet date, and then only if the amount involved were expected to be material.
What is a contingency? It is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss. The uncertainty will ultimately be resolved when one or more future events occur or fail to occur.
Resolution of the uncertainty may confirm the acquisition of an asset, the reduction of a liability, the loss or impairment of an asset, or the incurrence of a liability. If it is probable that an asset has been impaired or that a liability has been incurred at the date of the financial statements and the amount of that loss can be reasonably estimated, the loss is accrued by a charge to earnings and the recognition of a liability.
Contingencies require accrual. However, if it is only reasonably possible that a future event will confirm that an asset was impaired or a liability had been incurred at the balance sheet date, an enterprise must disclose the contingency if the amount involved could have a material effect on the financial statements.
The disclosure is to include the nature of the contingency and either an estimate of the amount of the loss or the range of possible losses:
- If an estimate of loss cannot be made, that fact must be disclosed
- If the likelihood is remote that a loss has been incurred, no disclosure is necessary in most circumstances.
However, guarantees of the indebtedness of others, guarantees to repurchase receivables or other assets, and obligations of commercial banks under standby letters of credit are always disclosed, irrespective of the likelihood of future performance on the part of the enterprise.
The required disclosure is to include the nature and amount of the guarantee. The current standard codification explains that guarantees actually embody two separate obligations:
- The contingent obligation to perform under the guarantee in the event of nonperformance by the party whose obligation is guaranteed; and
- An obligation to be ready to perform, referred to as a standby obligation, during the period that the guarantee is in effect.
(Source: ASC 460, “Guarantees”)
As a result of this bifurcation of the obligation, many guarantees are now required to be recognized as liabilities on the balance sheet. An estimated gain from a gain contingency usually is not reflected in the balance sheet or income statement because doing so might recognize revenue prior to its realization. Adequate disclosure of the gain contingency is to be made, but care must be taken to avoid misleading implications as to the likelihood of realization. For example, if the enterprise may be able to recover some portion of an incurred loss by proceeding against a third party, that fact might be disclosed.
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